Friday, July 19, 2013 - Lights Out on Paris of the Midwest

Lights Out on Paris of the Midwest

by Sinclair Noe

DOW – 4 = 15,543
SPX + 2 = 1692
NAS – 23 = 3587
10 YR YLD - .04 = 2.49%
OIL + .43 = 108.47
GOLD + 13.70 = 1297.70
SILV + .15 = 19.63

So, the big story today has to be Detroit. This isn't a story that moved the stock indices but it did rattle the $3.7 trillion municipal bond market. Selling picked up in the afternoon. Yields on longer-dated triple-A maturities ranging from 2037 to 2043 rose by 9 to 11 basis points. The rise was the steepest since June 24 after the US Federal Reserve rattled markets with talk about scaling back its bond buying program.

Detroit has filed for Chapter 11 bankruptcy reorganization. That's not a full fledged liquidation, which would be Chapter 7, so Detroit can continue to operate during reorganization, and they would then look to reduce debts by paying back a portion of what it owes. Right now, it looks like Detroit owes about $18 billion.

But this is not an easy deal, nothing about it has been easy; and the latest twist is that Circuit Judge Rosemarie Aquilina in Ingham County has said that the bankruptcy filing violates the Michigan Constitution and state law and must be withdrawn. In response, the state attorney general says he will appeal and seek emergency consideration from the Michigan Court of Appeals; and he has asked for a stay pending appeal.

Lawyers representing pensioners and two city pension funds got an emergency hearing Thursday with Aquilina, and she said she planned to issue an order to block the bankruptcy filing. But the lawyers for Michigan governor Rick Snyder asked for a 5 minute delay, and the Emergency Financial Manager, Kevin Orr had his attorneys file the Detroit bankruptcy petition in Detroit, in a different court, 5 minutes before the hearing began.

Aquilina said the Michigan Constitution prohibits actions that will lessen the pension benefits of public employees, including those in the City of Detroit. And Judge Aquilina says Snyder and Orr violated the constitution by going ahead with the bankruptcy filing because they know reductions in those benefits will result.

Assistant Attorney General Brian Devlin, representing the governor and other state defendants, said: “We can't speculate what the bankruptcy court might order," said

Aquilina replied: "It's a certainty, sir. That's why you filed for bankruptcy."

So pensions will be a huge part of the process moving forward, and there are some battle lines being drawn, but the battle lines have been forming for some time.

Kevyn Orr serves as the city's emergency manager, under a 2011 law some commentators have labeled "financial martial law." Once Gov. Rick Snyder (R) signed the law and appointed Orr, Detroit's city contracts and public properties were subject to Orr's sole discretion. Orr began selling off large chunks of public property, even attempting to sell off the city's art collection until the state Attorney General blocked him.

The appointment of Orr was controversial. As Emergency Financial Manager he basically runs the city, not the mayor, Dave Bing, who has been very quiet. And the citizens of Detroit do not have representation in their own city. This is a strange twist on democracy, and there have been voter challenges; overturned in emergency session; and there are lawsuits, lots of lawsuits. And there will be many more.

When he arrived on the job in late March, Orr took control of a city with an estimated $17 billion in long-term debts and a $327 million annual budget deficit. On July 12, the city announced it would stop making payments on about $2.5 billion in unsecured loans and asked some of its creditors — bond issuers, unions and pensioners — to forfeit as much as 90% of what the city owed them in order to avoid bankruptcy.

A primary reason anyone files for bankruptcy is to avoid lawsuits from creditors unwilling to take a large haircut. Detroit is no different. But those representing tens of thousands of city employees and retirees said they still intended to fight the case, particularly for the thousands of retirees who depend on city pensions. And whatever happens in Detroit will be closely followed. If you end up with precedent that allows the restructuring of retirement benefits in bankruptcy court, other cities might try the same tactic.

While a court can’t order a city to sell its assets, the city can sell off the ones it chooses. But many of those assets, like police cars or school buses, are vital to the functions of a city. Others, as Orr found out in May, when he reportedly contemplated selling the Detroit Institute of Art’s collection, are considered sacrosanct by the public.

Another challenge of a Chapter 9 bankruptcy is that it is difficult to get out of contracts negotiated under a collective-bargaining agreement. Detroit will have to prove to the court that dramatically renegotiating is necessary for the survival of the city. According to figures released by Orr’s office, more than 40% of Detroit’s revenues were spent on so-called required payments such as pension checks, bond liabilities, health care benefits and other dues, which are estimated to grow to 65% of the city’s spending in the next four years.

Detroit’s filing may be historic, but it is not unprecedented. Dozens of cities and counties have filed for bankruptcy over the years. The largest city to file for BK before Detroit was Stockton California in June 2012; with about $500 million in debt. Vallejo California filed for Chapter 9 because it couldn't pay its pension obligations. And Jefferson County Alabama, which includes Birmingham, filed in November 2011, after being bamboozled by Wall Street financiers.

Actually, JPMorgan Chase paid $75 million in cash and forfeit $647 in fees to clean up bribery charges involving a politician who green-lighted a series of deadly swap deals to finance a sewer system upgrade which ended up costing triple when the swaps turned bad; the $1.4 billion dollar sewer bond deal ended up becoming $3.9 billion in debt, and threatened to leave Birmingham high and dry.

There is a pattern of Wall Street siphoning off funds from municipalities, going back to the notorious Abacus deal executed by Goldman Sachs against Greece; to JPMorgan's conviction last year in Europe, along with several other banks, for fraudulent sales of derivatives to the city of Milan, Italy. A total of $120 was seized from Chase and three other banks in that case.

While Detroit certainly takes much of the blame for its debts, much of the borrowing the city engaged in under corrupt, jailed former Mayor Kwame Kilpatrick was ill-advised, it's a safe bet the city also got swindled by Wall Street, at least in part.

Numerous factors over many years have brought Detroit to this point, including a shrunken tax base but still a huge, 140-square-mile city to maintain; overwhelming health care and pension costs; repeated efforts to manage mounting debts with still more borrowing; annual deficits in the city’s operating budget since 2008; and city services crippled by aged computer systems, poor record-keeping, worse collection practices, and widespread dysfunction.

Detroit's population has has shrunk from 1.8 million in its heyday in 1950 to 700,000 today. Its tax base has collapsed. It's infrastructure is in shambles. Call 911 in Detroit and wait an hour for police to show up for an emergency. And by some reports, 40 percent of its street lights don't work. Detroit was once called the Paris of the Midwest – and now, it's lights out.

Bankruptcy would take months or possibly years and is itself expected to be costly and complex, and divisive. And then what? It’s not enough to say, let’s reduce debt. At the end of the day, you need a real recovery plan. Otherwise you’re just going to repeat the whole thing over again.

So, what can be done? The downward spiral began decades ago when deindustrialization led to depopulation, crime and declining public revenues. Corruption and mismanagement may have exacerbated the problem, but they weren't the root cause. The gravest mistake we can make today is to believe that Detroit is an anomaly. It isn't. The economic threats that brought down Detroit are present in other great American cities.

The idea that deindustrialization in America is nothing to worry about has been conventional wisdom for several decades. For a long time we have been under the impression that we can manage the finances and outsource the manufacturing; we can handle the design and outsource the production. But that's not how it works. Manufacturing and innovation feeds off the work of our friends and neighbors. The best designs come from people who actually, physically manufacture something. It may look good on paper, but can you really get a wrench in there and if you do, will your arm be in a position to actually turn it? And if you need a part, can you get it from the shop down the street or will you get it from a catalogue and have it shipped from China?

Our tax dollars fund research that helps create amazing products -- that are made overseas and sold back to us. We should insist that federally supported R&D is channeled into the design, engineering, and productions of goods in America.  We should encourage small scale manufacturers to localize manufacturing and reduce imports and establish a new generation of makers and innovators.  Financial deregulation in the late 1990s made the financial sector the master of manufacturing. That, along with the creation of CDOs, swaps, and other get-rich-quick "financial innovations," was a huge mistake. Ensure that our small- and mid-sized manufacturers have access to affordable, patient capital. Circulate money into smaller manufacturers and out of the financial market casinos. Restore the balance of power between the industrial park and Wall Street.

p.s. - here's the link to the Josh Rosner analysis of JPMorgan-Out of Control